The Income Tax Act, 1961 (IT Act) contains several provisions to prevent tax evasion. One such provision seeks to tax loans and advances made to shareholders by a closely held company as deemed dividends in the hands of the shareholders. This is intended to prevent tax evasion in situations where closely held companies distribute accumulated profit as loans or advances which are not chargeable to tax under the IT Act, instead of distributing it as dividends which is chargeable to tax under the IT Act. However, the said provision of deemed dividend is attracted subject to the satisfaction of the following conditions:
- The lender company must be a closely held company.
- Any sum is paid by way of loan or advance, otherwise than in course of ordinary business activities, to:
- A shareholder holding at least 10 per cent of voting power in the payer company;
- A company in which such shareholder has at least 20 per cent of the voting power; and
- A concern (other than company) in which such shareholder has at least 20 per cent interest.
- The lender company has accumulated profits on the date of any such payment and the payment is out of accumulated profits.
For a long time, there has been significant litigation regarding the applicability of this provision. Indian tax authorities would invoke this provision whenever they came across any related party transaction involving a grant of loans and advances, especially in cases where shareholders of the lender company were substantially interested. The Courts have stated that this provision would be attracted only if the shareholder itself received the requisite loans and advances. However, tax authorities continue to invoke this provision even when it involves other group entities belonging to the shareholder group.
This issue seems to have been resolved with the recent decision of the Hon’ble Supreme Court in the case of Madhur Housing[i]. The Hon’ble Supreme Court, while dealing with multiple appeals from various High Courts (HC) conclusively held that the provision of deemed dividends under the IT Act would not be attracted if the borrower is not a shareholder of the lender company. The Hon’ble Supreme Court upheld the decision of the Hon’ble Delhi HC in the case of Ankitech[ii] and has subscribed to the reasoning given by the Hon’ble HC in the aforementioned judgment, without giving any additional reasoning. Thus, it would be pertinent to examine the decision of the Hon’ble Delhi HC in the case of Ankitech.
Facts of Ankitech
The taxpayer company had received certain amounts as advances from another company ‘A’. The shareholders holding substantial interest in the taxpayer company, also held more than 10% voting power in A. The tax authorities held that since the shareholders who were holding substantial interest in the taxpayer company also held a substantial interest in A, which made advances to the taxpayer, the amount of loans and advances should be construed as deemed dividends.
However, the Hon’ble Income Tax Appellate Tribunal (ITAT) reversed the decision of the lower authorities and held that though the amount received by the taxpayer qualified as deemed dividends, it could not be taxed in the hands of the taxpayer company, since the taxpayer company was not a shareholder in A. The ITAT also clarified that such dividends could only be taxed in the hands of the shareholders who had a substantial interest in the taxpayer company and were also holding not less than 10 per cent of the voting power in A.
Decision of the High Court
The tax authorities were aggrieved by the relief granted by the ITAT, so approached the Hon’ble Delhi HC. The Hon’ble HC held that from the perusal of the relevant provisions, it appears that the intention of the legislature was to tax deemed dividends only in the hands of the shareholders of the lender company who holds substantial interest. The Hon’ble HC also observed that the deeming provisions were introduced to curb tax evasion resorted to by certain closely held companies which distributed accumulated profits as loans or advances instead of dividends and to tax such advances as dividends in the hands of the ‘shareholders’.
The Hon’ble HC further observed that the aforesaid provisions are deeming provisions, as the section creates a legal fiction that such loans and advances, which otherwise would not qualify as dividends, are in nature of dividend payments. Accordingly, the Hon’ble HC held that this deeming fiction is limited to enlarging the scope of the term ‘dividend’ and in no case can it be extended to broaden the understanding of the term ‘shareholder’. The Hon’ble HC also went on to further clarify that if it were the intention of legislature to broaden the definition of the term ‘shareholder’, it would have introduced similar language to that effect. The Hon’ble HC also relied upon the decision of the Supreme Court in the case of CP Sarathy[iii] and the decision of Hon’ble Bombay HC in the case of Universal Medicare[iv] respectively, to hold that in order to invoke the provisions pertaining to deemed dividends, the loan or advances must be advanced to shareholders or to a concern in which such shareholders have substantial interest and such shareholder must be both registered as well as a beneficial shareholder of the lender company.
The tax authorities attempted to place their reliance on the Circular no. 495 dated September 22, 1997, which provided that deemed dividends would be taxable in the hands of the concerned borrower. However, the Hon’ble HC rejected such claim and held that such circular was to no avail, as the correct legal position was that the deemed dividend income can only be taxed in the hands of the shareholders of the lender company.
The Hon’ble Supreme Court, by upholding the decision of the Hon’ble Delhi HC in the case of Ankitech, has cleared the clouds of ambiguity surrounding the taxation of deemed dividends and has clarified that loans or advances given to a concern in which the shareholders of the lender company are substantially interested would not be taxable as deemed dividends in the hands of the recipient, if the borrower entity itself was not a shareholder of the lender company.
This Hon’ble Supreme Court’s final decision is expected to grant relief to the taxpayers in respect of a number of other outstanding litigations . However, with the introduction of a number of anti-abuse provisions including the General Anti Avoidance Rule (GAAR), tax authorities are now legally empowered to challenge any transaction undertaken by taxpayers if such transactions cannot be substantiated on account of business expediency. Hence, taxpayers would be well advised to plan their tax affairs so that any such transactions can be justified with commercial rationale and meet “substance over form”. It must be remembered that aggressive tax planning could result in unwarranted litigation.
* The author was assisted by Bipluv Jhingan, Associate
[i] CIT v. Madhur Housing and Development Company Civil Appeal No. 3961 OF 2013 – SC]
[ii] [CIT v. Ankitech P Ltd. (2011) 11 taxmann.com 100 – Del HC]
[iii] CIT v. CP Sarathy Mudaliar (1972) 83 ITR 170 SC.
[iv] CIT v. Universal Medicare P. Ltd (2010) 190 taxman 144 – Bom HC.